Paul Krugman's Anti-China Protectionism Is The One Big Threat To The "Muddle Through"

If the Chinese allowed the renminbi to rise, would that make the
USA better off? That is the contention of a cabal of critics from
Senators to Nobel laureates. Paul Krugman wants to see a 25%
tariff on Chinese goods. Today we examine that idea, and look at
the real problems that we face. If only it were so easy. The
numbers just don't add up. The fault, dear Brutus...

O Canada

But first, and quickly, and in keeping with the spirit of the
recent Olympics in Canada, I want to let my Canadian readers know
that I am excited to announce a new Canadian partner, Nicola
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(In this regard, I am president of and a registered
representative of Millennium Wave Securities, LLC, member FINRA.)

The Threat to Muddle Through

I have pretty well laid out over the past decade that I think the
US will Muddle Through what promises to be a period of
below-trend growth and a long-term secular bear market. It will
not be pleasant or fun - there will be a lot of pain - but we
will get through the coming crisis (note: I think the Big One is
still in our future). That is what we do in a more or less
free-market world. But, as I wrote 7 years ago and have written
since, there is one caveat that turns me from a Muddle Through-er
into a real doom and gloom type, and that is the threat of
protectionism and trade wars. As in Smoot-Hawley, which made the
Depression into something much worse than it should have been.

Yet that is the prescription that Paul Krugman is advocating. In
a commentary in Sunday's New York Times (" Taking on China"), he called for an across
the board 25% tariff on Chinese goods:

"In 1971 the United States dealt with a similar but much less
severe problem of foreign undervaluation by imposing a temporary
10 percent surcharge on imports, which was removed a few months
later after Germany, Japan and other nations raised the dollar
value of their currencies. At this point, it's hard to see China
changing its policies unless faced with the threat of similar
action - except that this time the surcharge would have to be
much larger, say 25 percent."

Krugman doesn't think the Chinese can really retaliate by dumping
their hoard of dollars. He points out:

"It's true that if China dumped its U.S. assets the value of the
dollar would fall against other major currencies, such as the
euro. But that would be a good thing for the United States, since
it would make our goods more competitive and reduce our trade
deficit. On the other hand, it would be a bad thing for China,
which would suffer large losses on its dollar holdings. In short,
right now America has China over a barrel, not the other way
around."

I probably shouldn't take on a Nobel Laureate who got his prize
for his work on trade, but this truly scares me. People pay
attention to this nonsense, including the five Senators, led by
Schumer of New York, who want to start the process of targeting
China.

First, the Chinese have got to be wondering what they have to do
to make these guys happy. In 2005 they were demanding a 30%
revaluation of the Chinese yuan. And over the next three years
the yuan actually rose by 22% at a gradual and sustained pace.
Then the credit crisis hit, and China again pegged their
currency. From their standpoint, what else were they to do? Force
their country into a recession to appease our politicians?

They responded by a massive forcing of loans to their businesses
and governments and huge infrastructure projects. Kind of like
our stimulus, except they got a lot more infrastructure to show
for their money. It remains to be seen how wise that policy was,
and how large the bad (non-performing) loans will be that came
from that push - just as there are those (your humble analyst
included) who do not think the way we went about the stimulus
plan in the US was the wisest allocation of capital.

But the reality is that the Chinese will do what is in their best
interest. I wrote in 2005 that the yuan would rise slowly over
time. The political posturing of Schumer, et al., was
counterproductive then, and it still is now.

My prediction? The Chinese will begin to allow the yuan to rise
again sometime this year, just as they did three years ago,
because it will be to their advantage. A stronger yuan will act
as a buffer to inflation, which they may face due to the massive
stimulus they created. They are going to need some help in that
area. But it will be 5-7% a year, so as not to create a shock to
their export economy. Not 25% at one time. And at some point they
will allow the yuan to float against the dollar. They know they
will have to get the currency status they want. As an aside, are
we going to put a tariff on every country that pegs their
currency to the dollar? That is a whole lot of countries.

Back to 1971

By the way, let's go back to the 1971 that Krugman mentions. The
Japanese yen was around 350 to the dollar. They revalued by 10%.
Oh goody, salvation for the US. The yen is now at 90, and the
Japanese are still producing massive trade surpluses, about half
the size of Chinese surpluses, with less than one-tenth of the
people. That is an almost 75% devaluation, and yet the world
keeps buying Japanese products.

Why? Because they make good stuff we all want. The Chinese could
raise the value of the yuan by 25% over the next year and they
would still run a surplus, because like the Japanese, they make
good stuff we want at prices we like. Would their surplus still
be as high? No. Because a 25% increase in prices would mean that
we could afford less of what they sell. But of course it would
also give them wider profit margins, which would help hold their
trade surplus up.

And it would also introduce inflationary increases in our imports
and higher prices for lower-income families. Yes, a 25% tariff is
such a smart idea that it took a Nobel laureate to think it up.

What Krugman argues is that we should pay more for Chinese goods,
so that we will buy less of their goods. As if we wouldn't buy
the same goods from Vietnam or Brazil or Pakistan, if those goods
were cheaper than Chinese goods. For the life of me, I can't see
how substituting goods from foreign countries other than China
helps our trade deficit.

Are we going to start targeting the currencies of every nation
that runs a surplus with us? What about Europe? And Great
Britain? Their currencies are dropping against the dollar, in the
case of England rather precipitously. Are they pursuing
mercantilist policies, Senator Schumer [in reference to his
recent scandalous press conference]? What happens when the euro
goes to parity against the dollar (and it will!) because the
Europeans are having trouble getting their act together? Are we
going to demand they force the euro to rise? Tell the ECB to
raise rates and shove the whole euro area into an even worse
recession?

Do you think Japanese businessmen believe the yen is too strong,
and we should make the dollar stronger against the yen? What are
we going to do in three years when the yen is at 150 on its way
to 300 because Japan is getting ready to hit the wall, due to
their massive government deficits? Accuse the Japanese of
mercantilism and try and force them to revalue the yen?

Maybe Canada should put a 25% tariff on US goods, because their
dollar has risen by almost 40% against ours in the last few
years. That would teach us a lesson. It would also destroy trade
and a very good relationship.

It is a dicey damn world we live in. We are coming to the end of
the debt super cycle, as I have written elsewhere in this letter.
It is a very perilous time. Things are going to be hard enough.
We have a huge problem with deleveraging and controlling our
fiscal deficits, not just in the US but in the entire developed
world. Starting trade wars is the absolutely worst possible thing
to do. For the US to even suggest that such a policy is
reasonable is the worst possible kind of message. Where are the
adults in the administration?

The fault, dear Brutus, is not in our stars,
But in ourselves, that we are underlings.

Let's look at the actual trade deficit. This past month it rose
to $40 billion, but that is down from the $70 billion it was only
a few years ago. Over half that deficit is oil and energy. The
Chinese "deficit" fell to a four-year low.

Trade deficits actually matter in a deleveraging cycle. Let's go
back to the Outside the Box I sent you a few weeks ago from Rob
Parenteau and review.

"... if we divide the economy into three sectors - the domestic
private (households and firms), government, and foreign sectors -
the following identity must hold true:

"Note that it is impossible for all three sectors to net save -
that is, to run a financial surplus - at the same time. All three
sectors could run a financial balance, but they cannot all
accomplish a financial surplus and accumulate financial assets at
the same time - some sector has to be issuing liabilities."

As Rob noted, this is an "identity" equation. It is always true
for all nations. In order for the US or any nation to be able to
see both its government and private sectors reduce their leverage
or deficits, the country must run a trade surplus.

Let's look at the implication of that equation. Most everyone in
the US (other than Paul Krugman and his fellow uber-Keynesians)
think that reducing the federal deficit would be a good thing.
And the private sector is busy reducing its leverage and
"deficits" as well. But if we really want to reduce the
government and private deficits at the same
time, we have to be able to run a trade surplus.

Those numbers must ALWAYS add up to zero. The US
trade deficit is due to a lack of savings in the US. No one is
forcing us to buy goods from abroad. If we saved more and bought
less we would have a trade surplus. It's really that simple.

Another implication. And a rather sobering one. For the US
to continue to run such massive government fiscal deficits,
either the private sector is going to have to massively increase
its savings or we will have to reduce the trade deficit by buying
less goods and energy, or some combination of the two. There is
no other option. And if the savings of the private sector are
funneled into government debt, then that crowds out private
investment. And it is private investment that produces jobs.

GDP = C + I + G + Net Exports

The above equation is another identity equation. It says that
Gross Domestic Product is equal to total Consumption (consumer
and business) plus Investments plus Government Spending plus Net
Exports (which in the case of the US is a deficit and in the case
of Germany or China is a surplus).

We are going to examine this in great detail in the coming weeks,
as there are serious implications for the economy contained
within these simple terms.

But for our purposes today, if you play with the above equation a
little you find that savings is equal to investments. But if the
government "dis-saves" or runs a deficit, that means that savings
have to go to cover the government deficit, which means there is
less for investment. And it is investment that produces jobs.

Krugman and the Keynesians are right in this regard. If
consumption falls, as it does in recession, then a corresponding
increase in "G" helps offset that drop. But Keynes assumed that
in good times government would run surpluses. It seems that we
forgot that part.

What Greece is learning, as will all nations, is that you cannot
increase "G" in an unlimited fashion. There is an end to the
ability of governments to get investors to lend them money. That
level is different for different countries, but the work of
Rogoff and Reinhart (which we have looked at extensively in
previous letters) clearly shows that at some point, and generally
rather dramatically, markets lose confidence in the government's
ability to pay, and the game stops.

Let's assume (and here I put on my optimist hat) that the US
decides that reducing our deficit over time is a good thing.
Fiscal conservatives get into Congress and we reduce the deficit
by (say) $200 billion a year for five years, with a growth in
revenues, so that the budget deficit is less than the growth in
nominal GDP.

The first identity equation says that to do so we must either
increase savings or reduce the trade deficit or some combination.
If we use all our savings to cover the government deficit, then
we have nothing left for private investment. And yes, it is not
quite that simple, as we could use already accumulated savings,
but over the medium run, large government deficits will crowd out
private investment, the engine of job growth.

As we will see in a few weeks, reducing "G" (government deficits)
in the short run is a hit to GDP. There is no question about
that. But in the medium run (we no longer have the luxury of the
long run) running massive deficits, as we are now, will mean that
we, too, will become Greece. As will much of Europe and Japan if
deficits are not brought under control.

It is not a question of pain or no pain. We are going to have the
pain. The question is whether we take it in small doses or all at
once. Slow growth, or a depression?

Part of that process that we MUST address is getting the trade
deficit down, as we need that money for handling the deleveraging
process.

A rational energy policy that gets us off foreign oil as quickly
as possible must be enacted. Senator Schumer, if you are so
worried about deficits, why not demand that we drill for oil
offshore on the continental shelf, where we know there are
massive deposits? And why not aggressively encourage the use of
natural gas in the medium term for transportation? Nuclear
energy?

And why are we not aggressively doing as many open-trade
agreements as we can? Columbia and Korea have been done, and it
would open up those markets for our exporting businesses. Yes,
they get a shot at us, but I will bet on the home team. Our
exports are growing every month. It seems, Senator, that you
oppose all those policies. But simple accounting demands that we
reduce the trade deficit, and tariffs are the worst possible way
to try to do so, and won't work. And the possibility of a trade
war and the real damage to our export sector? I really get
alarmed.

Instead of bashing China over their currency valuations, let's
challenge them where it would make a difference, on opening up
their markets to our products and businesses more than they
already do. Seriously, if we did impose a tariff on Chinese
goods, US consumers would just switch to goods from other
countries. It would be meaningless. But if we could sell more to
them?

If we are going to put our fiscal house in order in the US, we
are going to have to get a handle on our trade deficit. The
operative word is "our." Not Chinese deficits. They are not
responsible for what we choose to buy.

When we look into our economic mirror, we must confess, "We have
met the enemy, and he is us." We can't borrow our way out of a
debt crisis, Paul. At some point, we just have to get on with it.

One last thought. The whole world cannot run a trade surplus.
Someone must actually consume. Germany and Japan are also running
huge surpluses. Many of the problems in the peripheral European
countries are because they are running trade deficits. Would not
the rational extension of Krugman's and Schumer's ideas mean that
we also target Germany and Japan? The world is out of balance,
and getting it back will not be easy, and certainly not easier if
we all pursue beggar-thy-neighbor policies.

An Optimistic New Venture, San Diego, and New York

Let me express my thanks to ProFunds, Rydex/SGI, Trust Company of
America, and Ceros for sponsoring the CMG Advisor Forum that I
hosted along with good friend Steve Blumenthal of CMG. There was
a good crowd (about 70) of advisors and brokers from all over the
country, and we finished the day at my house for Texas BBQ. If
you are an advisor or a broker (or an investor) and want to see
the outstanding platform of traders Steve has assembled, then go
to http://www.cmgfunds.net/public/mauldin_questionnaire.asp
and they will get in touch with you.

Just for the record, I am helping to start a new software
company. I will write about this later, but I think there is a
large opportunity in new-media and mobile software, and I have
persuaded an experienced executive in the industry to start a new
venture with me. I will be providing the money and nothing much
else, as what I know about software is limited. But I am
convinced after a lot of research and discussion that there is an
opportunity.

And that is how recovery happens. Someone sees an opportunity and
takes a chance. Some of them work out. Most of them don't.
Believe me, I know. Yet, if all goes well we could create a dozen
jobs this year. Not a lot, I know, but it all adds up.

And what I saw in Cincinnati simply amazed me. A whole new
mega-health-care business will be born in the next few years. I
will give you more on that later.

The world is not ending. It is changing and adapting.

I will be in San Diego twice in April, once for my conference,
which is now sold out, and again for Rob Arnott's annual
conference. In between I will be in New York for a speech and an
appearance/interview with Steve Forbes, which should be fun.

I will be a panelist in the inaugural "America: Boom or
Bankruptcy?" summit to be held in Dallas on March 26. There will
be five of us, presenting problems (plenty of those!) and
possible solutions. This promises to be a no-holds-barred,
full-throttle event. It should be a ton of fun. Details at
www.fedfriday.com.

Once again, it is time to hit the send button. It is late and
there is a lot to do tomorrow. I have it blocked off as a day
with my youngest son, ending with the Mavericks playing the
Celtics. The Mavs are starting to look decent as we move into the
playoffs. But then so are many other teams. We will see. Have a
great week.

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